"China's 2008 economic stimulus programs may have been necessary for stabilization, but they appear to have been too large, too intensively focused on fixed assets and too heavily concentrated on construction," Mukherji wrote in a 2012 note.

"All this stimulus led to massive increases in domestic capacity for steel, cement and aluminum - while demand from export markets fell and property deflated amid financial tightening. As a result, these industries experienced massive excess capacity."

In the 2012 Central Economic Work Conference— in which officials assess the current state of the economy and draw on this to set the tone for the next year's macroeconomic policy — fixing overcapacity was once again made a priority as China begins to rebalance its economy.

The IMF's Article IV assessment published in 2012 put China's average capacity utilization about 60% at the end of 2011, from 80% at end-2007. Capacity utilization is a way of gauging slack in the economy.

This chart from SocGen draws on the IMF report to show the decline in capacity utilization:

Societe Generale

The IMF said at the time that China had suffered excess capacity and utilization rates that were constantly below 80% since the 2000s. In 2007, strong external demand helped push the utilization rate higher, but this took a hit again after the Lehman crisis.

While GDP growth recovered quickly after the crisis, the IMF found that China has been growing below potential since 1997, and that the problem isn't just cyclical.

China can't count on external demand to close output gap, neither can it unleash more stimulus, Societe Generale's Wei Yao wrote in a 2012 note.

Excess capacity impacts many Chinese industries including chemicals, ferrous and non-ferrous metals, and newer industries like renewable energy. China's solar power industry has been hit by anti-dumping and anti-subsidies investigations.

The inventory of finished goods sub-index in China's manufacturing PMI report, climbed to 50.2 in March. This showed that excess capacity conditions were deteriorating. This has since fallen below 50 but not enough to for concerns to wane.

The excess capacity in Chinese industries has weighed on producer prices too, which were down 2.9% in May. The decline in producer prices shows that China is growing below potential, and CLSA's Christopher Wood who has been tracking PPI writes that "this is as good an indicator as any of the deflationary excess capacity in the system, which is why local fund managers are fond of tracking the correlation between PPI and nominal GDP growth and also more recently with the A share market."

What does this mean for the economy. And how can it be fixed?

Local governments have only contributed to China's excess capacity woes.

"The problem is that much of the so-called 'blind' and 'redundant' investment that Beijing would like to eliminate has the strong support of local governments, whose primary concern is with generating GDP growth in their jurisdictions, regardless of whether the means of achieving it make any economic sense," wrote Mark DeWeaver in a Project Syndicate column.

"As to how to resolve the problem of excess production capacity, Central Economic Work Conference raises "4 batches": consuming one batch by creation and expansion of domestic demand, transferring one batch to overseas by speeding up going out process; integrating one batch by optimization of organizational structure; eliminating one batch by rigorizing environmental security energy consumption admittance standards.

"As for steel industry specifically, in resolving steel overcapacity contradiction we must respect the laws of market, rely on market-based instruments and eliminate a number of capacity through market competition. Although at first there will be loss of some resources in this process, it can't be avoided, iron and steel enterprises must work hard. We should also go out actively and transfer industrial chain; actively promote the merger and reorganization of steel industry, improve the variety and quality of products and enhance market competitiveness and viability."

This basically means "faster depreciation and slower new investment growth," for China, according to Yao. And that in turn means sectors that are already struggling with excess capacity will feel more pain as they begin to deleverage and consolidate.